There are two ironclad rules I follow when it comes to investing:
- I don't buy energy stocks of any kind. I don't understand the industry, and I've been burned before.
- Under no circumstances do I buy shares of any company based in China.
Let me be clear. I have nothing against China. My second rule isn't due to any specific negative experience I've had with Chinese stocks. And that's because I've never owned a China-based stock. I hold this rule because I simply don't trust the financial statements coming out of some high-flying companies based there. Fundamentals don't matter if you can't be sure the numbers are real.
I'm not in the business of betting against companies that I think might be trying to deceive investors. I've never shorted a stock in my life, and I likely never will. When I invest, I want to feel completely confident about every aspect of a company -- this means looking under the hood and making sure the numbers, management, and business model are sound. And being intimately familiar with its market. Maybe these guidelines mean I'll miss out on opportunities, but I'll also avoid major errors.
Fraud can be revealed by a crisis
Fraud is often unmasked during crises, as the conditions necessary to keep the deception going vanish. Enron was the big scandal of the dot-com bubble, while Bernie Madoff's Ponzi scheme headlined the financial crisis.
Fast-growing Chinese coffee chain Luckin Coffee (LKNC.Y -0.98%) may not turn out to be the biggest fraud that collapses during the novel coronavirus pandemic, but it is the first of any significance. On Thursday, the company announced that the preliminary stages of an investigation uncovered fabricated transactions throughout 2019 that greatly inflated its results. The company blamed chief operating officer Jian Liu and several other employees for the misconduct.
The scope of the fraud at Luckin makes it highly unlikely that the COO was the only executive aware of what was going on. The board of directors identified 2.2 billion yuan of fake transactions from the second quarter of 2019 through the fourth quarter of 2019, equivalent to $310 million at today's exchange rates.
In the second and third quarters combined, Luckin reported total revenue of $348.1 million. The company hasn't yet reported its fourth-quarter results, but it guided for revenue of roughly $290 million. That means that nearly half of the company's revenue during those periods was fake. Luckin's board also discovered that certain costs and expenses were substantially inflated during this period.
Luckin's growth during 2019 seemed too good to be true: Revenue was up more than 540% in the third quarter. Now we know that wasn't truly the case.
Err on the side of caution
Perhaps Luckin was the only company to inflate its earnings or lie to investors. But I have my doubts.
I'd prefer not to sift through Chinese stocks looking for companies that are likely to be totally above board. Instead, I choose to err on the side of caution by avoiding them. With the stock market down hard over the past month, there are plenty of opportunities among U.S. stocks with financial statements I can trust, thanks in part to stricter transparency regulations following our own brush-ups with fraud during past crises.
One positive thing that comes out of any crisis is the unraveling of frauds. Luckin was the first. It probably won't be the last.